China Continues to Change

March 16, 2018 Ian Taylor

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Over the past 30 years, China has engineered an astonishing rise from underdeveloped country to global economic superpower. It’s easy to forget, in the midst of this phenomenon, that China is not a democratic country. However, we are sometimes issued stark reminders, as we were a few days ago when China’s legislature voted to remove presidential term limits.

China has been wrestling with “free-market” economic problems while it also turns a crucial corner from industrial manufacturing to a more consumer-driven economy of goods and services. There is an argument that the limits were removed more for economic reasons than strictly political ones.

A shift to the middle class

I grew up in a Canadian town completely dependent on forestry, and I saw the effects of increased competition from emerging markets through the early 2000s. Even 10 years ago, the prevailing investment view was that emerging market stock returns were inseparably linked to the commodity markets.

Times have changed and evidence can be seen in the composition of the MSCI Emerging Markets Index. Commodity producers such as Brazil and Russia have fallen materially as a percentage of the index while Asia and China in particular have expanded. More importantly, sectors such as consumer discretionary and information technology are playing a much larger role. China-based technology companies such as Tencent and Alibaba now account for more than 9% of the index. These changes are being driven by China’s burgeoning and free-spending middle class.

Where economics meet politics

Before domestic consumers became an economic factor in China, growth was led by state-sponsored investment in heavy industries. However, this form of growth isn’t sustainable and this underpins the desire to move towards a greater reliance on domestic consumption. This rebalance has important political implications for the region and the Chinese government believes it calls for the re-centralization of power to give the state greater control over the deleveraging process and the reduction of excesses created by the investment boom.

The announcement about presidential term limits is an indicator of that re-centralizing of power—China’s policy makers have been clamping down on economic and financial imbalances. The decision to merge the China Banking Regulatory Commission and the China Insurance Regulatory Commission and moving some regulatory and oversight functions to the People’s Bank of China (China’s central bank) is a recent example of sweeping changes to China’s financial system in an effort to reduce systematic risk.

Relatively stable global economic conditions at the present time enable Chinese policy makers to accelerate the pace of changes, so it would not be surprising to see more activity in the weeks and months ahead.

The investment outlook for China

From our perspective, stability in China is important because the country is a key component of our global outlook. More than half of global economic output is accounted for by China, the U.S. and the Eurozone. Challenges in any of these three markets will create difficulties for the entire global economy.  We believe Chinese policy makers are well positioned to handle the economic transition with its direct control over its financial sector and its extensive foreign reserves.

As emerging markets are set to continue growing at a faster pace than developed markets, we see significant opportunity for investors to benefit from China’s economic potential. In the MD Global Tactical Opportunities Pool, for example, we maintain an increased allocation to global equities based on expectations for solid global growth in 2018, including rapid growth from China.

About 24% of the MDPIM Emerging Markets Equity Pool, is allocated to Chinese equities, of which 4% is held in A-shares (traded on Shanghai and Shenzen stock exchanges, denominated in Renminbi and typically restricted to Chinese nationals). Our Chinese stock selection is domestically focused, with many of the shares purchased either through an investment bank, or by using the Hong Kong Connect program.

Some of our notable holdings include Kweichow Moutai, the world’s most valuable liquor company having recently eclipsed Diageo. Kweichow makes a famous brand of Chinese baijiu that earns 90% profit margins and sells at up to £300 at Heathrow Airport duty free.

We also have a position in Yili Inner Mongolia Holdings, a dairy company making fresh milk, yogurt and non-perishable milk products. The company has an enterprise value more than twice that of Canadian competitor Saputo.

Holdings in Chinese giants Alibaba and Tencent are showing rapid revenue growth as the companies have created a duopoly over China’s mobile payments that dwarf those in the U.S. Alibaba’s sales on Singles' Day (a popular Chinese shopping holiday) single-handedly  outpaced all of America’s Black Friday and Cyber Monday sales.

And the list goes on, including direct access to buy debt securities on China’s interbank bond market in the opportunistic portion of MD’s bond mandates. All of which begs the question, should we be alarmed or acquiescent about China’s approach to politics? Only time will tell, although we believe like most of the world that China is currently placing economics at the forefront of its agenda.

 

About the Author

Ian Taylor

Ian Taylor, CFA, CIM, is an Assistant Vice President with the Investment Management and Strategy team at MD Financial Management. He oversees strategic and tactical asset allocation mandates, alternative investment mutual funds and is a member of MD’s Tactical and Risk Allocation Committee.

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